Chapter 1: What Is Bitcoin?

In this chapter, I will try to give you an overview of Bitcoin. If you are already familiar with Bitcoin and its revolutionary nature, you can easily skip this chapter. For all the others, I will try not to overcomplicate things. It is important to have a basic understanding about the blockchain and Bitcoin because that’s how all of this had started.

1.1 The Rise of Bitcoin

A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution. Digital signatures provide part of the solution, but the main benefits are lost if a trusted third party is still required to prevent double-spending. We propose a solution to the double-spending problem using a peer-to-peer network. The network timestamps transactions by hashing them into an ongoing chain of hash-based proof-of-work, forming a record that cannot be changed without redoing the proof-of-work. The longest chain not only serves as proof of the sequence of events witnessed, but proof that it came from the largest pool of CPU power. As long as a majority of CPU power is controlled by nodes that are not cooperating to attack the network, they’ll generate the longest chain and outpace attackers. The network itself requires minimal structure. Messages are broadcast on a best effort basis, and nodes can leave and rejoin the network at will, accepting the longest proof-of-work chain as proof of what happened while they were gone.

What you’ve just read is the abstract of the original Bitcoin whitepaper—nine pages, 3,641 words, 21,443 characters to change our understanding of money, banking, and basically the world as we know it. You don’t need to worry at all if the abstract above is too hard to understand as a whole. I included the abstract to give you an idea how everything had started in the first place. The whitepaper is available online (https://bitcoin.org/bitcoin.pdf) and is definitely worth a read, as it represents a very important part in the history of cryptocurrency. But as I wanted to make the book beginner friendly, I will try to explain how Bitcoin works in a simple way.

1.2 Bitcoin made simple

Since the major rise of Bitcoin in late 2017, most people will have heard about it as some sort of virtual money or digital gold. Even though this is basically just the first major application, it is a good point to start from. Bitcoin is indeed completely digital money, as no physical form exists. It is a universal currency that can be sent, received, and stored and that requires no middleman to be involved (i.e., traditional banks). The concept is truly revolutionary and was made possible only after Satoshi Nakamoto had solved the so-called double-spend problem in 2008.

The identity of Satoshi Nakamoto remains a mystery, even though some people have tried to claim credit for the invention of Bitcoin.241, 242 Satoshi Nakamoto disappeared from public eye in late 2010.239 In his honour, the smallest unit of one Bitcoin (0.00000001 BTC) is called Satoshi (often abbreviated to “Sats”).

So the idea for a peer-to-peer digital currency was nothing totally new. But as everything was digital, the process had to ensure that the related files of the corresponding currency couldn’t simply be counterfeited. Alternatively, anyone would be able to spend or use the same Bitcoin multiple times, which is the underlying principle of the double-spend problem. Using blockchain technology, Satoshi Nakamoto found the solution by making every transaction and account open to everyone who wanted to verify any Bitcoin transfer.

It’s important to know that even though every transaction and account is public, your private information that grants access to your money is never shared. Solving this crucial problem allowed the breakthrough of Bitcoin as a digital currency. For the first time ever, you were now able to be your own bank. Before Bitcoin, you would always have to rely on some sort of middleman to keep track of every money movement. This had multiple disadvantages: transactions were slow, high fees could be claimed, and only a minority of the potential clients around the world could actually access the currency—to name only a few.

Now, from the perspective of the Bitcoin network, everyone is equal and can transfer the funds beyond national borders faster and cheaper than ever before.

1.3 How does all of this work?

If you’ve already heard about Bitcoin, there is a good chance that you’ve also heard about blockchain. As we now want to understand how Bitcoin works, I will try to explain the underlying principle as simple as possible.

As the name blockchain implies, it is simply a chain of consecutive blocks linked together. Each of the blocks holds a certain amount of valid transactions of the network. As the blocks are chained together, the resulting blockchain therefore represents a record of every transaction made and is often referred to as a decentralized, immutable, open ledger. As this public ledger stores the information for every transaction, every bitcoin transfer and holding can be easily verified as well. At variance with the traditional system—where you need to trust your bank, for example—every user of the bitcoin network keeps track of the exact same blockchain. Users from all over the world can work together to secure the network by making sure that every attempt of fraud gets noticed and rejected. This process of coming to an agreement that the different copies of blockchains match is called consensus. The first and best-known mechanism of reaching consensus is the Proof-of-Work (PoW) algorithm. Bitcoin utilizes the so-called SHA-256 (Secure Hash Algorithm) to keep the blockchain secure. Those actively willing to deliver a proof of work are called miners. Miners use computational power to basically solve highly complex puzzles and verify the most recent transactions of the network. Many miners from all over the world compete with each other for the next block to be rewarded. Miners who are to generate a new block are rewarded with newly created bitcoins and all the transaction fees included in the respective blog. The current block reward is 12.5 BTC and halves every 210,000 blocks (roughly four years). The next bitcoin “halving” is therefore estimated to occur in mid-2020. As there will never be more than 21 million bitcoins in existence, the creation of new bitcoins is estimated to end in the year 2140. Beyond this point, miners will receive no new bitcoin, but still the transaction fees of the respective block. But since mining contributes to the functionality and security of the network, mining will still continue after all the bitcoins will have been created. The difficulty to generate a new block is adjusted by the underlying protocol depending on the total amount of computational power used for mining. The aim is to ensure the rate of block generation to be constant over time, even when the contributing computational power changes. The time to generate a new block, is called block time and averages ten minutes in the Bitcoin network.243 One of the key features that makes Bitcoin and Cryptocurrencies so innovative and unique is the decentralized structure of the network. At variance with centralization, there is no single entity, government, or organization in control of the network. Hence, there is no need to trust a central authority, and no one is able to block certain transactions or stop the network in any way. This grants a higher level of security and functionality, since the risk of having one central point of failure can be minimized. Thanks to all of those features and innovations, the Bitcoin network has been stable and secure since the early days of 2009.

1.4 Using Bitcoin

If you start using Bitcoin, you will most likely be surprised how similar some of the terms are to those in the traditional banking system. Even though all of the terms are somehow “broken” in relation to Bitcoin, they will help us to understand and use Bitcoin immensely.

Let’s start with the Bitcoin wallet. For explanatory purposes, it is often referred to as the regular wallet you use every day. However, in Bitcoin, the wallet does not actually hold your coins or credit cards. It contains your private key(s) that basically allow you to spend the Bitcoin you control. You could therefore imagine your wallet to be similar to a keychain. The wallet shows your coin balance and allows you to spend your coins by sending them to a specific address. Transferring coins and therefore money is pretty simple, as the bitcoin address is quite similar to a bank account number or email. It is a unique string of numbers and letters that allows you to send and receive bitcoins, without the need of telling anyone additional personal details. This is something absolutely unique, as you can transfer money across the globe for a small fee with just a simple Bitcoin address. As the Bitcoin network is public, you are free to check the balance corresponding to an address or transactions made at any given time. It is important to know that you don´t need to keep your Bitcoin address secure and disclosed all the time. You can share your address on the Internet, draw it to the street, or basically do everything you wouldn’t with your traditional bank accounts. Your Bitcoin address won’t allow anyone to access your coins in any way; therefore, you don’t need to worry about sharing it.

We need to get a little technical here for a second, because there is a lot confusion about the terms Bitcoin address and public key. The only thing you should remember is that they are NOT the same. First of all, let’s get back to the wallet, or better keychain, once again. As mentioned above, it contains your private keys. Your private key is string of letters and numbers that can roughly be compared to a password, giving you access to your email or bank account. As with every password, your private key should never be shared with anyone! If someone manages to get access to your private key, he is in control of your coins. Please, handle those keys with care! In terms of Bitcoin, your private key is basically a signature that is used to authorize outgoing transactions and therefore spend bitcoins that are associated with the corresponding Bitcoin address. Now, we can come back to public keys and the Bitcoin addresses. Public keys are directly derived from the private key and are used to verify the signatures, and, therefore, the outgoing transactions are valid.

A Bitcoin address is a 160-bit hash of the public portion of a public/private ECDSA keypair. Using public-key cryptography, you can “sign” data with your private key and anyone who knows your public key can verify that the signature is valid.244

As I’ve already mentioned, you don’t need to remember the technical details above. Basically, the Bitcoin address is a processed version of your public key, and both descend from your private key. That’s the reason why you don’t need to remember all of your Bitcoin addresses or any public keys at all (as your wallet will handle everything automatically, you will almost never get in touch with your public key, in general). The only thing you need to have access to is your private key. That’s why storing your coins on an exchange is not the best idea, as you don’t own the private keys. But that’s something we will talk about in detail in chapter nine. There, we will look into the different kinds of wallet and their advantages or disadvantages. If you want to get started with Bitcoin, there are several ways to do so. One of the most common starting points right now is definitely <coinbase.com>. You can deposit any supported currency by bank wire and exchange it for Bitcoin very easily. But this isn’t the only way. Depending on the country you live in, you could even just go to a Bitcoin ATM and buy a certain amount easily via your credit card. Having a trusted way to buy Bitcoin is very important, as you dive deeper into the whole cryptocurrency space. Many new tokens and coins can’t be bought directly by exchanges like Coinbase or ATMs. Therefore, later on, you will need to acquire Bitcoins to exchange them for some other currencies if you want to. That brings us to another very important question: Where are Bitcoins or other cryptocurrencies actually stored? This question is especially interesting because we’ve already learned that our wallet isn’t the right place to search. The reason for this is simple—because in Bitcoin, there are no coins like we would imagine them. Hence, there is no real storage of coins—rather, the transactions or ledger entries are recorded on the respective blockchain. Thus, miners, for example, don’t mine “coins”; they basically mine ledger entries as the corresponding mining reward is credited to their balance in form of a transaction. If you now want to send your best friend some number of coins across the globe, a transaction is sent to the Bitcoin network, which is checked on validity. If the transaction exceeds your personal balance, it will be rejected and therefore not processed. As every transaction and balance is open to the public, everything can be verified quite easily. If valid, the transaction is broadcast to the network and added into a new block. The number of coins is subtracted from your balance and added to the one of your best friend’s. Depending on the wallet you chose, using Bitcoin can be very intuitive. It is almost like using a regular bank account, even though the fundamentals couldn’t be more different.

1.5 What makes Bitcoin so special?

On the following few pages, I would like to highlight some of the features that make Bitcoin so revolutionary and special. Even though, there are definitely far more ways to use Bitcoin, I hope that the provided examples help understand why blockchain technology and cryptocurrency could have a major impact on the world as we know it today.

1.5.1 Banking the world

Having access to a bank account or being able to use credit cards has become self-evident—especially for most of the Western society. But even though global and national efforts are slowly paying off to further increase the access to any form of banking services all over the world, some countries—especially the emerging ones—are still lagging behind. The 2017 Global Findex Database report estimates that around 1.7 billion adults remain unbanked worldwide, which equals roughly 31 percent.246 The leading cause, named by nearly two-thirds of all the unbanked adults, is the lack of money. About 22 percent name the distance to financial institution as a barrier. Interestingly, 16 percent cite distrust in the financial system as one of the reasons, with some greater regional differences. The number of people distrusting the financial system is about twice as high in Europe, Central Asia, or Latin America than it is in the rest of the world.

Even though Bitcoin and cryptocurrencies might not be able to solve all the problems that lead to the lack of banking access, they can provide some previously unimagined opportunities. This becomes evident as we look at the percentage of unbanked adults owning a mobile phone. It is estimated that around 1.1 billion of the total 1.7 billion adults worldwide have their own mobile phone. The number of adults that additionally have access to the internet is about half of the original count. In sum, roughly about one third of all unbanked adults globally could not only benefit from using bitcoin, they could rather become their own bank. This could be a life-changing opportunity for almost half a billion people around the globe.

As opening up a traditional bank account generally requires some sort of authentication, using Bitcoin may facilitate the process in even the most rural regions. Due to the open nature of the Bitcoin network, there is no need to trust financial institutions or the government. Since aside from the minimum fees, Bitcoin is free to use, even some small amount of money can be saved and worked with easily. Increasing access to traditional financial institutions in different areas of the world still requires investing a lot of effort and time. As even some older phones can run wallet apps (e.g., Samourai Wallet) without any problems, millions of people could therefore start using Bitcoin almost immediately. Even though mass adoption could be accelerated immensely by the ability to pay any kind of bills or services with crypto, giving people the ability to send and receive money easily could still have a major impact worldwide.

1.5.2 Programmable money

Over the years, many people have asked me questions of the following nature: “Why do you think a simple software program could revolutionize the world?” or “How can a program be trusted to handle my precious money?” I actually like those questions, because I’m amazed how self-evident some of the recent technological innovations have become. This gets especially interesting if we look at younger generations. Some won’t remember the time when smartphones weren’t Internet accessible. And I am not even talking about the time before the Internet and mobile phones! If we look at our daily lives, software and technical innovation literally rules everything around us. Without the Internet and personal computers, life as we know it wouldn’t be possible. Surely, you could call your friends, using an analogous phone—but that’s if you still owned one and knew how to use it. For many people that use Paypal, online banking, and credit cards frequently, the idea of using digital currencies is nothing unimaginable at all. From my personal experience, this is also the case when it comes to the generations that have already experienced some major technological innovations (e.g., Walkman, CDs, MP3s, and now streaming) as our world is changing with sometimes unimaginable speed.

So, should we be shocked that the financial sector must undergo some major changes as well? Well, the game changes when it comes to money. Especially in the Western world, the traditional financial system has some very strong roots. Some European countries, for example, basically “got lost” due to their governments’ inability to keep up with the pace of technological innovation in the modern world. Imagining that some software could render one of the key fundamentals of the traditional world unnecessary is way off their personal horizon. Even if they could imagine it and might even see the advantages, why would they want it to succeed anyway? Money is power. As long as you control people’s money, you basically control the people that own that money. Even though I personally appreciate regulations of the whole cryptocurrency sphere, I am afraid that some of the current world leaders still underestimate the potential that Bitcoin has.

And today, cryptocurrencies are especially needed more than ever. Credit cards were born in the 1950s; they were simply not made for the Internet age.245 An amazing book series The Internet of Money from one of the leading and most respected figures in the crypto community, Andreas M. Antonopoulos highlights the need for Bitcoin in the modern world.

For some, there is simply no need for Bitcoin, as they are already able to send money quite easily with services like Paypal, for example. But even though Paypal might seem revolutionary, it still relies on our traditional banking system. Hence, it still has to deal with all the flaws of the traditional banking system as well.

Even though it might be scary to trust software with your hard-earned money, instead of the traditional banking system, software has some major advantages. Software is programmable. Bitcoin, therefore, is constantly evolving. That’s something what makes Bitcoin so powerful and so different from the traditional banking system. If you want to help improving Bitcoin, you can simply contribute. No one can stop you.

Yes, it is no secret that the Bitcoin network is constantly under attack, with people trying to break the code. Basically, nothing would be more rewarding in the world to successfully crack the code and simply print as much Bitcoin as you want. It may surprise you, but that’s actually a good thing. The network needs to be attacked to evolve and mature. Investing in Bitcoin and cryptocurrency is a high-risk investment right now, but that doesn’t make the idea or the technology less powerful. There is a lot of development going on to further improve the Bitcoin network and increase scalability and mass adoption. Lightning network, atomic swaps, or Schnorr signatures are only some of the possible future implementations and possibilities that we haven’t even thought of yet.

I know everything may seem scary right now, but this is not the first revolution of money in history. Just think about the transition from gold to our well-known paper money. The level of skepticism and aversion must have been unparalleled. Such transition must have been especially unthinkable, since it involved a high level of trust, and paper has no intrinsic value after all. Another relatively recent example is the transition from paper money to credit cards. Even though credit cards have been available for more than half a century, a lot of people still prefer the good old paper money. If you keep those two examples in mind, using cryptocurrencies like Bitcoin in the future doesn’t sound too crazy after all, does it?

1.5.3 Modern hyperinflation

Let’s begin by looking at inflation, which can be defined as constant price increase of goods and services for a certain time period. As the general price level is increasing, the purchasing power of the respective currency is falling. The inflation rate is specified in percentage, and some examples can be seen below:247

– Australia 2.3%

– Belgium 1.8%

– Canada 2.2%

– China 2.0%

– France 1.5%

– Germany 2.0%

– United Kingdom 2.2%

– United States 2.3%

As you can see above, all the numbers are close to 2%, which represents the general aim of central banks. The European Central Bank (ECB), for example, states:

The primary objective of the ECB’s monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term.248

The yearly inflation rates are constantly changing and aren’t always as close to the desired 2 percent as shown above. It is definitely worth noting that you should aim for a yearly salary increase of at least the level of inflation. Otherwise, as the purchasing power of your currency declines, you would basically lose money every year.

Now, it is time to see what constitutes hyperinflation. According to the Cambridge Business English Dictionary, “economists generally reserve the term ‘hyperinflation’ for cases when the monthly inflation rate reaches over 50 percent.”249 So basically, as the term already implies, hyperinflation is an extremely rapid form of inflation. Just think about the definition above for a second. The prices of the goods and services are rising by more than 50 percent, rendering the purchasing power of your currency to half what it was at the start of the month.

Back to history again. The Weimar Republic (Germany) became one of the best-known examples in the 1920s. To pay for the reparation debts following World War I, the government started to print huge amounts of new cash. Combined with a collapse of the economy and a shortage of goods, the resulting hyperinflation was around 20 percent per day or roughly 30,000 percent per month. Hungary of 1946 became the victim of the worst hyperinflation recorded to date.. At its peak, prices doubled roughly every 15 hours, which led to an increase of 1.3 x 1016 percent per month (130,000,000,000,000,000%). In Zimbabwe, a serious hyperinflation peaked around the year 2008, with the prices doubling every 24 hours. The inflation rate reached around 79 billion percent per month.250–252

All of those numbers may seem absolutely unimaginable, but there are some nations suffering from the serious inflation or even hyperinflation at the time of writing. The Turkish inflation rate, for example, reached a new 15-year high of around 25 percent in September 2018.253 That might not seem huge in comparison to some numbers of the past, but the country needs some intervention, as the inflation rates tend to increase rapidly. Iran is another country with a significant inflation rate. Due to economic sanctions, the inflation increased from 8 percent in April to around 18 percent in July.254 Venezuela is the most recent example. In 2017, the rate of hyperinflation was at the 1,000 percent mark. It is expected to get close to the 1.4 million percent mark this year, eventually reach the 10 million percent mark by end of 2019,255, 256 and thus add Venezuela to the list of the worst cases of hyperinflation in human history, truly jeopardizing the well-being of the population. After all, around 91 percent of Venezuelan families already live below the poverty line, with roughly 65 percent facing extreme poverty.

At this point, you may ask yourself what all of this has to do with cryptocurrencies and Bitcoin. As people suffer from ongoing price increases, they tend to search for alternatives. Traditionally, foreign reserve currencies (e.g., USD or Euro) as well as gold have been preferred viable solutions. With cryptocurrencies, a new possible solution is now available. Even though cryptocurrencies, like Bitcoin, are considered to be very volatile in comparison to traditional assets, their risky nature becomes relative in comparison to some of the inflation rates mentioned above. Some even think that hyperinflation could lead to a so-called hyperbitcoinization as Bitcoin becomes the dominant national currency.

But even though the local Bitcoin-trading volume has been constantly increasing in Venezuela, hyperbitcoinization is far off from reality right now. The reasons for this are rather simple. First of all, countries like Venezuela don’t have the technical infrastructure needed for a fully digital currency yet. Hence, some foreign currencies or gold, if available, are still more useful in wide areas of the country. Although Venezuela’s government is about to issue a backed cryptocurrency themselves, a widespread adoption is still unlikely in the very near future.

That doesn’t mean, however, that cryptocurrencies couldn’t be a viable solution for a certain portion of the population and thus help significantly. It shouldn’t surprise you much that some of the countries with the highest inflation rates also have some of the highest rates of cryptocurrency ownership. Although those studies might not be the most accurate ones, as reliable numbers are generally hard to estimate, it could signal for some major changes in the way people deal with inflation—especially as there is often a general shortage of foreign currencies and gold in nations facing high rates of inflation. With an increasing level of digitalization worldwide, cryptocurrencies might turn out to be the best solution for millions of people, as their usage provides various advantages. People could reduce the impact of governmental actions, prevent their savings from devaluation, or pay directly from one person to another by simply downloading a wallet on their phone and starting to use cryptocurrencies. Bitcoin and cryptocurrencies might not be able to solve the problem of inflation or hyperinflation in general, but they might still open up some unprecedented possibilities.